On why there should never be a referendum on debt.
Prospect theory (Kahneman and Tversky, 1979 – or later Cumulative prospect theory, 1992) describes decision making about gains and losses. By presenting a person with a choice about gains the person will, on average, choose to secure their gains. On the other hand when presenting a person with a choice about losses the person will, on average, be willing to risk the losses in hope of making them disappear.
Say I were to give you a choice:
a) Either I give you a $1000 or
b) we flip a coin and either you get $2000 or you get nothing at all.
What would you select? Here the theory tells us that people tend to secure their gains and select a).
Say I were to present you with another choice:
a) Either you give me $1000 or
b) we flip a coin and either you give me $2000 or nothing at all.
What would you select? Here the theory tells us that people tend to select choice b) – loss aversion. This holds true even if the probability of the loss disappearing is very little.
This explains the behavior of a gambler (dare I say stockbroker?) who is unable to stop her double-or-nothing betting because she is so certain that on the next throw of the die she will have made the debt disappear.
This decision bias is very well documented and is one of the founding research behind Kahneman’s and Tversky’s behavioral economics, for which Kahneman received a Nobel prize in 2002. (The Nobel is never awarded posthumously, and came to late for Tversky).
Loss aversion is very relevant to what is happening in my little country of Iceland these days. On March 6th the voters were called to the polls to vote on the Icesave repayment plan. Prospect theory effectively means that any referendum on debt will end up with the majority of the voters electing to risking the debt in hopes of lowering it. Even if the probability of the debt disappearing is close to none. Even if it may mean accumulating a much larger debt.
The only way to fight this bias is by changing how the choices are presented. By applying prospect theory shows that a decision can be influenced by changing the frame of reference of the choices. If the debt is framed as losses (which it usually is) the result will always be that people are willing to risk it. If the debt is framed as gains (from a previous offer for example), people will want to secure these gains.
And so the outcome of any referendum can be manipulated by the framing of the proposition. A decision such as this needs professionals. People that are able to dive into the issue and avoid the bias. That is why there should never be a referendum on debt.
– Last paragraph added after first publish (copy/paste fiasco 😉 )*